Should Your DC Plan Include Absolute Return Strategies?

May 28, 2014 (PLANSPONSOR.com) – A paper from Towers Watson recommends, for defined contribution (DC) plans, up to 25% of traditional U.S. aggregate bond assets can be switched to absolute return assets.

“Unconstrained Bond Investing: Examining the Case for
Absolute Return Strategies for DC Participants” looks at how switching a
portion of conventional bonds into some form of absolute return strategy may
improve DC plan outcomes. The paper cautions, however, that investors need to be
mindful of the risks introduced and ensure sufficient focus is placed on
retaining a robust strategic asset allocation and achieving value for money.

With interest rates at or near historic lows across
developed worlds, absolute return investing is attracting much attention, says
Latham, adding, “There is a great deal of emphasis on evolving defined
contribution plans to aim for improved retirement outcomes. DC plans have
historically been anchored to a simple Barclay’s Aggregate benchmark, resulting
in a U.S. interest rate and geography bias. Our analysis concludes that a more
diversified approach can have a meaningful impact over the long-term for DC plans.
In a total portfolio context, our analysis reveals that diversifying bond
exposure beyond traditional structures has the potential to improve the risk
and reward profile and outcomes for participants.”

The paper notes that the idea of interest rates and yields
being more likely to increase than decrease has important implications for the
sort of bond products that asset managers are launching. Recent years have seen
a variety of products launched to exploit or protect against the “seemingly
inevitable rise of bond yields.” This includes funds that are variously labeled
as absolute return bond funds, unconstrained bond funds and numerous other
strategies.

The
paper defines absolute return bond funds as funds with a goal of creating an “all-weather” portfolio
that is robust across market environments. In addition, such funds should
deliver strong returns over the medium term, but will regularly have single
years of negative returns. Absolute return bond strategies have low interest
rate sensitivity, typically with a neutral duration position close to zero, and
may have the scope for small negative duration, benefiting directly from rising
yields.

The paper defines unconstrained bonds as those utilizing strategies
that seek to generate positive returns in all market environments. These funds
typically permit the flexibility to lever up returns, express an absolute
negative duration position and generally carry more and lower quality credit
risk, including sub-investment grade credit.

While the attention surrounding absolute return bonds has
been driven by expectations and concerns over rising interest rates, the paper
notes that it is important to retain a more holistic and longer-term
perspective when assessing the merit of adding these strategies. The paper further
notes that most investors do not have the time and investment insight required
to successfully switch between strategies across an economic cycle, pointing
out that it is “unrealistic and dangerous to try to optimize portfolios to a
specific macro regime that may prove to be relatively short-lived, or indeed
take some time to materialize.” Instead, the paper recommends
identifying a structure that is a good fit for the current macro regime and
across a market cycle.

In terms of how a DC plan sponsor can determine the best
route for implementing various absolute return type solutions, Latham explains,
“In our analysis, we shifted a portion of a total portfolio to an absolute
return strategy, which resulted in improved risk-adjusted returns in a total
portfolio context. We do not believe offering an absolute return strategy as a
stand-alone option on a DC platform is the right approach. Our view is that DC
plans should de-emphasize single style investing and aim for simplification to
aid participants in decisionmaking.”

Latham clarifies that strategies such as absolute return
should be offered within a diversified structure such as white label funds or
as part of a custom target-date fund series. She acknowledges that while this
approach is a higher governance proposition, it also allows portfolios to be
approached in “a more holistic manner.”

The paper also recommends an assessment framework for
different absolute return strategies involves testing their efficacy against
key goals of such an allocation. These rules for assessment include:

Do not increase the correlation to equity. Any
investment strategy change must be assessed against the impact on the overall sensitivity
to equity markets and overall level of risk.

Improve returns in a rising interest rate environment.
This can mean either structurally different exposures or more dynamic
management of exposure.

Improve robustness of returns in all environments.

Do not increase correlation to current investments or
the dependence on existing managers.

Find a solution that is appropriate to DC participants. “Appropriate”
is defined as being liquid in nature and easily understandable to participants.